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Stagflation or reflation?

There is a building narrative that the world may be shifting from a reflation to a stagflation regime. While it is likely that global growth will slow as emergency stimuli are unwound and that inflation will stay elevated for longer due to supply constraints, we believe key indicators are not pointing to a stagflation outlook. As such, we would use any market dislocation to add exposure to risk assets.

Equities: Technical indicators and fundamentals point to limited further downside in US and Euro area equities. We prefer the Value sectors, which are likely to benefit from the reflation theme.

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Bonds: We continue to believe Asian High Yield bonds offer attractive value. US bond market history suggests High Yield bonds deliver strong returns in the 12 months after a period of substantial yield spread widening.

FX: EUR/USD has strong support near 1.1490, though there is a risk of final capitulation of long EUR positions.

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Stagflation or reflation?

A confluence of factors has led risk assets to swoon and bond yields and the USD to rise in recent weeks. Increasingly hawkish central banks, global energy shortages, prolonged supply bottlenecks, China’s continued policy-driven slowdown and US debt default concerns have all played a part in building the narrative that the world may be shifting from a reflation to a stagflation regime. While it is likely that global growth will slow as emergency stimuli are unwound and that inflation will stay elevated for longer due to supply constraints, we believe critical indicators are still not pointing to a stagflation outlook.

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If anything, the rise in real (net-of-inflation) bond yields and steeper bond yield curves in the US and Europe since the Fed’s and ECB’s latest policy meetings suggest investors have a renewed faith in reflation. We expect stronger US and Euro area growth and moderately higher inflation in the coming year compared with the pre-pandemic decade. This reflationary outlook is backed by a few other metrics: (i) US and European High Yield (HY) bond spreads over government bonds, often indicators of a downturn in the economic cycle, remain close to record lows; (ii) global business confidence (PMIs) stabilised at robust levels in September, especially in the US, after a few months of slowdown; (iii) US and European new orders-to-inventories remain robust amid severely depleted inventories; (iv) global COVID-19 cases and hospitalisations continue to fall, including in the US, as vaccinations rise; (v) an oral COVID pill from Merck, which could cut hospitalisations; (vi) the US job market continues to improve, with jobless benefit claims at pandemic lows, and; (vii) US long-term inflation expectations remain within their long-term range (though German expectations have risen to the highest since 2013).

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Of course, we would closely watch several near-term risks, including US Democrats’ ability to get their proposed fiscal spending package approved by the Congress (debt ceiling concerns have eased for now with the Senate agreeing to raise the ceiling till December). The nature of a future German government is important for European risk assets, with a coalition comprising of the socialist SPD, the Greens and the liberal FDP likely to lift fiscal spending. The other focus is on China: will it succeed in ring-fencing Evergrande’s challenges and take steps to prop up growth? Finally, we need to see whether Russia’s offer of more gas supplies to Europe and China’s move to lift coal supplies ease their energy shortages.
A harsh winter amid energy shortages risk further fuel inflation, with knock-on effects on growth and inflation expectations.

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While these challenges could sustain short-term market volatility, we expect them to be resolved favourably as most are policy-driven and governments are ultimately likely to favour sustaining the reflationary environment. In the US, Democrats can use the so-called reconciliation process to get a spending bill approved by the Congress (albeit with a curtailed spending plan). Meanwhile, major central banks have emphasised they remain data driven. Their recent hawkish stance is based on the significant recovery in job markets since the depths of the pandemic. They are also, arguably, buying insurance against any prolonged burst of inflation. We expect them to push back against rate hike expectations if their economies slow.

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As such, we see any further decline in risk assets as an opportunity to add exposure to our preferred assets, especially US and Euro area equities, where the earnings outlook remains robust, and US and European HY corporate and Emerging Market (EM) and Asia USD bonds (see pages 4-5). The renewed outperformance of Value stocks is in line with our long-held view that Value-style is likely to benefit from the reflationary regime. The recent outperformance of sectors linked to the economic reopening theme suggest investors are also backing a reflation, instead of a stagflation, outcome.

— Rajat Bhattacharya